Why Value Investing Works

{ Euclidean Q3 2015 Letter }

We are in the midst of a volatile period for stock market investors, one that follows five years of growth stocks outperforming their out-of-favor, value counterparts. This has been a challenging time for Euclidean’s investors. Our recent results have provided little validation for your belief in our investment process.

Our confidence in Euclidean’s prospects for delivering attractive returns, however, remains strong. We believe that buying historically good companies at pessimistic prices is a sound way to compound wealth over the long term, and we observe that in the past, our form of investing would have had to endure other periods with little positive feedback. That there are difficult periods is a big part of why we believe value investing works over time. If value investing was both fruitful and easy, everyone would embrace it, and the opportunities we seek would never emerge.

This letter is devoted to reviewing these perspectives in some detail.

Cycles of Value and Growth Investing

In August, we published a data post that received some attention. It showed that value outperforms growth across most five-year periods and does so by roughly 5% annualized over time [1]. However, it also showed very clearly that value investing does not outperform all of the time. In fact, there have been six periods since World War II when growth outperformed value on a trailing five-year compounded basis. This is relevant as we are currently in one of those periods, with the last one occurring in the late 1990s during the dot-com era.

Below is the first chart from that post, with data updated through July 2015.

The data shows that in the past when growth has outperformed value, value did very well over the subsequent 5+ years. Yet, as this has yet to occur in this current period, it is useful to ponder a few questions:

Why does value investing work over time, and why should we expect it to do well in the future?

What is value investing really? The data above classifies stocks based on how expensive they are in relation to their book values. But value investing is not simply selecting investments based on a company’s price-to-book value, so why is this data helpful?

How does all of this relate to Euclidean’s investment process?

Why Does Value Investing Work Over Time?

The observations that value investing does well over time but doesn’t work all of the time go hand in hand. Periods of underperformance and short-term market volatility can make value strategies difficult to stick with. But it couldn’t be any other way. If value investing was both fruitful and easy, everyone would embrace it, and the opportunity to do well with value strategies would disappear.

So the more interesting question isn’t why value might work over time but not all of the time, it’s why value investing works in the first place.

We believe the leading actors of the “why value works” story are investors who behave as though price and value are the same thing. For these investors, everything that matters about a company shows up in its share price, leaving no need to understand the businesses underlying the shares they trade. Because just about anything — a Fed meeting, a speech in Greece, a report on China’s economy, etc. — can impact the prices on which they focus, these investors end up in a recursive effort to predict the future and how other investors will react to current events.

“Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.'”

One consequence of there being a large number of price-focused investors is that they cause share prices to periodically diverge from the cash-generating capabilities of the companies those shares represent [2]. These disconnects, once present, can widen and last over long periods as they are amplified by behavioral biases that are hardwired in human nature. Among them are recency bias, where investors experience the same current trends and extrapolate them into the future, and, confirmation bias, which causes investors to feel validation when other investors bid up the same stocks they hold.

Thus, in periods such as the past five years when growth stocks do well, investor confidence grows in the safety and merits of owning growth stocks. Likewise, many investors begin to wonder if value investing is a thing of the past. As a result, expensive companies become progressively more expensive and risks build for investors who pay premium prices. Meanwhile, cheap companies become relatively less expensive as they continue to underperform, and opportunities emerge where the share prices of certain out-of-favor companies fall below their estimated values.

During previous eras of growth stock outperformance, Benjamin Graham’s weighing machine eventually reemerged as a force much like gravity and provided investors with a stark reminder that price and value can be two very different things. Share prices quickly adjusted back toward companies’ intrinsic values, resulting in strong relative returns for value investors and disappointment for those owning expensive stocks.

As when growth stocks outperformed in previous cycles, we believe investors today have not been appropriately distinguishing between price and value. We anticipate that we will eventually experience an outcome analogous to what has followed these periods in the past, and the wisdom of adhering to a value approach will once again be on display.

What is Value Investing Really?

Here is our take at a definition: value investing is the discipline of seeking investments that are priced at material discounts to estimated values. Implicit in this definition is the notion that price and value are distinct concepts. In the public markets, price is easy as it is provided every second for all to see. Conceptually, value should be easy too. Like with a bond, the intrinsic value of a company is simply its future cash flows (or equity coupons) discounted back to the present. So, value investing is the discipline of seeking to pay low prices for high future cash flows.

The complication comes from companies — unlike with most bonds — having future cash flows that are uncertain in both magnitude and timing. Thus, the value investor’s challenge is to best estimate those future coupons and be influenced by market prices only in so far as they allow those estimated cash flows to be purchased at a discount, such that a margin of safety is secured.

So, in what ways does this relate to the chart on the first page, which distinguishes companies based on the relationship between their market prices to their book values?

Book value reveals very little about the operations of a company; it makes no distinction between a pile of cash and a company with productive assets, great products, and loyal customers. It is therefore interesting that the ratio of book value to market value could hold information that might be useful in determining which companies might do well or less well as investments over the long term. Here are the two important points to consider:

1. There is an average amount of earnings companies have realized over time in relation to the equity capital (or book value) invested in their businesses. This is the concept of return-on-equity, and you can measure it retrospectively for any company or the public market as a whole. If investors are not very good at predicting companies’ future earnings — and there is good evidence they are not [3] — then by buying a basket of companies that have low prices to book value, you will end up paying relatively low prices for an average collection of future earnings. It seems reasonable you might do better with this practice than those who pay average or high prices for similar future earnings.

2. The true value of an asset comes from its discounted future payments. While that value cannot be precisely estimated for a company, it will be related to qualities that are intrinsic to its business, such as its balance sheet, its margins, and its sales. Perhaps then by grounding investment decisions in something knowable and intrinsic to a business — even something as simple as its book value — you can do better than basing decisions on past price movements or predictions regarding how extrinsic factors may impact its business. More importantly, as this form of simple approach seems to have done well in the past, perhaps there is an opportunity to do even better with a more robust process for evaluating the intrinsic worth of individual companies. Euclidean’s goal, and we think the goal all value investors, is to define as robust a process as possible for assessing business value and then to adhere to it over a very long period of time.

Selecting investments based on a company’s price-to-book value is obviously not all there is to value investing. What the price-to-book-based analysis hints at, however, are the merits of qualities that all value investors share, namely that you focus on qualities about a business as opposed to external factors and that you pay attention to market prices only in so far as they present the opportunity to buy shares at large discounts to what you conservatively estimate are their inherent worth.

Certainly the great legends of value investing — the Klarmans, Ruanes, Schlosses, and Buffetts of the world — have gone and do go much deeper than any simple ratio when they are selecting investments. They do so presumably because they believe there are other relevant considerations to valuing a business.

How This Relates to Euclidean

Like the legends of value investing, we believe that there are better ways of assessing a company’s value than crude measures such as price-to-book or price-to-earnings, and we attempt to develop a nuanced view of a company’s true character by analyzing its operating history. Our tools are in the field of machine learning, and we look for those qualities that historically would have been helpful in identifying when the market has underpriced a company’s underlying business value. The characteristics we have found to be meaningful about companies include

Low prices in relation to average earnings,

High consistency of operations over the long term,

High returns on capital, and

A conservative balance sheet.

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This foundation has us holding a portfolio with a number of favorable qualities when viewed in relation to the S&P 500. In aggregate, our holdings are growing faster and generating higher returns on capital, and they are doing so with much less leverage. Most important, our collection of companies with these favorable characteristics is priced in relation to average earnings at a 40% discount to the market as a whole.

As growth stocks have been in favor, and as current market volatility reflects investors’ efforts to anticipate the Federal Reserve’s actions and make sense of developments abroad, we have continued to establish holdings in good companies at attractive prices. For this reason, and in the context of how value and growth investing cycles have worked over time, we expect to deliver attractive long-term results to Euclidean’s investors.

[1] Historical results represented herein are for illustrative purposes only and are not based on actual performance results. The hypothetical portfolio and the associated returns do not reflect the effect of transaction costs, bid/ask spreads, slippage, or management fees. Historical results are not indicative of future performance. Please see the appendix of the referenced data post for full details on the results.

Philip E. Tetlock, Expert Political Judgment: How Good Is It? How Can We Know? (Princeton University Press, 2005)

We share these numbers because they are easy-to-communicate measures that show the results of our systematic process for buying shares in historically sound companies when their earnings are on sale. [4][5]

It is important to note that Euclidean uses similar concepts but different measures to assess individual companies as potential investments. Our models look at certain metrics over longer periods and seek to understand their volatility and rate of growth. Our process also makes a series of adjustments to company financial statements that our research has found to more accurately assess results, makes complex trade-offs between measures, and so on. These numbers should, however, give you a sense of what you own as a Euclidean Investor. In general, higher numbers for these measures are more attractive. The key measures are:

1) Earnings Yield – This measures how inexpensive a company is in relation to its demonstrated ability to generate cash for its owners. A company with twice the earnings yield as another is half as expensive; therefore, all else being equal, we seek companies with very high Earnings Yields. Earnings Yield reflects a company’s past four-year average earnings before interest and tax, divided by its current enterprise value (enterprise value = market value + debt – cash).

2) Return on Capital – This measures how well a company has historically generated cash for its owners in relation to how much capital has been invested (equity and long-term debt) in the business. At its highest level, this measure reflects two important things. First, it is an indicator of whether a company’s business is efficient at deploying capital in a way that generates additional income for its shareholders. Second, it indicates whether management has good discipline in deciding what to do with the cash it generates. For example, all else being equal, companies that overpay for acquisitions, or retain more capital than they can productively deploy, will show lower returns on capital than businesses that do the opposite. Return on Capital reflects a company’s four-year average earnings before interest and tax, divided by its current equity + long-term debt.

3) Equity / Assets – This measures how much of a company’s assets can be claimed by its common shareholders versus being claimed by others. High numbers here imply that the company owns a large portion of its figurative “house” and, all else being equal, indicates a better readiness to weather tough times.

4) Revenue Growth Rate – This is the annualized rate a company has grown over the past four years.

[4] All Euclidean measures are formed by summing the values of Euclidean’s pro-rata share of each portfolio company’s financials. That is, if Euclidean owns 1% of a company’s shares, it first calculates 1% of that company’s market value, revenue, debt, assets, earnings, and so on. Then, it sums those numbers with its pro-rata share of all other portfolio companies. This provides the total revenue, assets, earnings, etc. across the portfolio that are used to calculate the portfolio’s aggregate measures presented here.

[5] The S&P 500 measures are calculated in a similar way as described above. The market values, revenue, debt, assets, earnings, etc., for each company in the S&P 500 are added together. Those aggregate numbers are then used to calculate the metrics above. For example, the earnings yield of the S&P 500 is calculated as the total average four-year earnings before interest and taxes across all 500 companies divided by those companies’ collective enterprise values (all 500 companies’ market values + cash – debt).

Euclidean’s Largest Holdings as of September 30, 2015

We provide this information because many of you have expressed an interest in talking through individual positions as a means of better understanding how our investment process seeks value.

We are available to discuss these holdings with you at your convenience. We are happy to explain both why our models have found these companies to be attractive as well as our sense of why the market has been pessimistic about their future prospects.

Euclidean’s ten largest positions as of September 30, 2015 (in alphabetical order

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